Index Funds and ETFs Distort The Market

There once was a maxim among professional investment managers.

“Small investors are always wrong.”

It might still be there, but more on that later.

I think they mean those with only a little capital, but perhaps it is the not tall crowd. At one time there was little evidence to the contrary. But things have changed.  Change has effects.

If professional fund managers are expert and wish to make money in the market, they must be more expert than others or they could not buy cheap enough or sell for more than a stock is worth. You will notice that “fund manager” in this context does not include managers like Buffett, Munger, Klarman, and others, who buy pieces of a business and care less about what the market tells them. For them, the market is just a place to go to see what is on sale or what is trading at too high a price.

The way Scott Adams saw it 20 years ago.

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Things have changed. Fund managers have fewer poorly informed traders to take advantage of.

A recent Wall Street Journal article noticed that Vanguard now has more than $4 trillion in assets under management and they are growing quickly.  More than half of the net inflows of money in 2016 went to Vanguard. Low fees are very attractive, but there is a flaw.

There are a finite number of shares available and index funds cannot own all of them.

At the extreme, what if they owned it all and someone came along with more money to invest?

Nothing available to buy and no prices in any case.  What would happen then?

Somewhere between index funds own 0% of the market and they own 100%, is a tipping point where the market fails to tolerate the concentration.

Which brings us back to the beginning. Are small investors still always wrong?

Maybe they are and the run to index funds and ETFs will turn out poorly. If you would like depth on this subject, look at The Rise of Passive and Indexed Investing, and its Effect on Market and Liquidity Risk by Andy Martin here. He has a good book too.  Dollar Logic.

Index funds are like other techniques in the market. They work when only a few people use them. Anything everyone knows is not worth knowing. Like The Efficient Market Hypothesis. It works until everyone knows about it.

Seth Klarmann points out,

“The irony of the efficient market theory is the more people believe in it, the more inefficient the market is likely to become.”

Future money will be delivered according to the underlying fundamentals of your investment choice. It will be a smart move to understand those before relying on their continuing value in a market environment dissimilar to the one that created them. Past experience is only valuable if future conditions are similar.

Try to understand the meaning of what you see.

Low management fees are wonderful if you don’t lose track of the idea that you are saving money for a future use and the money can’t tell how you got it.  Besides our mothers always told us it is impossible to get something for nothing.

Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario.  In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.

Please be in touch if I can help you.  don@moneyfyi.com  866-285-7772

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